Ten questions about borrowing to clear up before your building project begins

Mr Zhang’s investment property sits on 900 square metres of land. Under the Unitary Plan, the site is in the Mixed Housing Urban zone. After discussions with a planner, he learned that the site could be subdivided to build 4 standalone homes. With no development experience or knowledge of construction lending, Mr Zhang entrusted the borrowing arrangements to a mortgage brokerage. As the developer, however, he still has plenty of questions he would like answered.

Many applicants are likely to share Mr Zhang’s concerns, even after finding a professional mortgage adviser to help prepare their application documents and follow up on progress. So what are the questions people most often ask? We hope the following answers will help.

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Question one: How much can I borrow for my construction project?

Answer: The amount you can borrow depends on the project’s value. Lending ratios will, of course, differ between banks and finance companies.

• Finance companies: You can usually borrow 65% of the combined land value and construction costs, or 70% of the project’s valuation.
• Banks: You can usually borrow 80% of the project’s valuation. If you are a professional with a very high income, you may even be able to borrow 90%.

Question two: How much is the interest? What other fees will I need to pay?

Answer: Interest and associated fees depend on the rules of the bank or finance company and the loan term. The longer the term, the higher the interest.

Possible costs include legal fees, interest, line fees and broker fees.

Question three: What is a line fee, and how does it differ from loan interest?

Answer: A line fee is a charge some finance companies apply to the total loan facility, from acceptance of the loan until repayment, to reserve funds held by the lender that have not yet been used. Most line fees are charged monthly. Loan interest, by contrast, is usually charged as a percentage of the amount drawn down.

Suppose Mr Zhang borrows a total of NZ$1,000,000 from a finance company, of which NZ$100,000 has been drawn down for the foundations. Interest is charged on the amount drawn down, so at this point he pays interest on NZ$100,000. The line fee, however, is charged on the entire available credit facility, so Mr Zhang must make monthly payments to the finance company calculated as a percentage of NZ$1,000,000.

Although not every finance company charges a line fee, borrowers should check for this clause before signing a contract, as it can be a substantial expense. For example, Company A charges 6% interest plus a 3% service fee and a 1% line fee, while Company B charges 7% interest plus a 3% service fee. On the face of it, 6 + 3 + 1 = 7 + 3 = 10. But will the customer’s total costs differ?

Because interest is calculated progressively on the amount actually drawn down, while the line fee is always calculated on the total loan facility, 1% interest will cost less over the full loan term than a 1% line fee.

When choosing a loan offer, therefore, do not judge it solely by the interest rate. Check whether a line fee will also apply.

Question four: How long is a construction loan term? Are repayments during construction interest-only?

Answer:

Interest-only repayments are relatively common: interest is paid monthly, with the principal repaid when the loan matures. Some finance companies instead require both principal and interest to be repaid at maturity, with capitalised interest added to the principal. Ultimately, the repayment arrangement depends on the finance company’s operating model.

Question five: When subdividing and redeveloping an investment property, how does holding it personally or through a company affect borrowing?

Answer: First, if you borrow from a finance company, it can lend only to a company. Second, holding an investment property subdivision and redevelopment in a company usually allows GST to be claimed. We recommend discussing the specific arrangements with your accountant.

Question six: When is a valuation report needed?

Answer: Not every financial institution requires a valuation report. Some finance companies assess projects using factors such as nearby house prices, government valuations and the experience of their finance professionals. However, rapid market changes or the risk management requirements of finance companies and banks may make a valuation report a firm lending requirement.

• Some finance companies include a valuation report as a condition of their loan offer. In that case, the customer can wait until they accept the offer before commissioning the report.

Some financial institutions release funds based on valuation reports at each stage of construction. Customers then need to arrange a valuation report before each drawdown.

Question seven: What if I cannot afford the builder’s deposit after signing the contract? Can a loan cover it?

Answer: When signing a full build contract, you usually need to pay the builder an advance payment, generally no more than 10% of the construction cost.

    Some customers have already put most of their own funds into buying the land and therefore hope to borrow to pay the deposit. The first thing to establish is whether there is already a loan secured against the project’s land:

• If there is no loan, or borrowing has not reached the maximum loan-to-value ratio (LVR), the land can be used as security for a top-up loan to help cover the shortfall.
• If the mortgage on the land has already reached the maximum LVR, consider whether the customer has another property or a vehicle that could be used as security.

Question eight: When does a construction loan start releasing funds? How are they released, and are there any fees?

Answer: A construction loan is drawn down progressively as the build advances. Applications must be supported by invoices or valuation reports at each stage. Photographs showing progress on site may also be required to demonstrate that the money has genuinely been spent, all expenditure is in line with market prices, and the project is worth the stated amount at that stage.

Financial institutions generally have their own drawdown schedules. For a simple illustration, the construction programme in a full build contract can be divided into five stages: foundations, floor and roof framing, external lining, lock-up and completion. Funds are released after each stage, covering the work just completed. In practice, the process is more complex and involves more steps.

Bear in mind that some financial institutions, though not all, charge a drawdown fee each time funds are released, usually between NZ$50 and NZ$200.

 

Question nine: Will the bank or finance company advance money for construction, or must I pay upfront?

Answer: This depends on whether the project’s “land” has sufficient equity. Property value minus existing borrowing equals equity. If there is enough, funding can be obtained through a mortgage, or home loan.

• If not, the construction loan will not provide funds to the customer in advance.

For risk management reasons, banks and finance companies require customers to fund the initial construction work themselves. This demonstrates that they have the financial resources to continue the project or cover costs if it goes over budget. The first drawdown is therefore usually released only after customers have completed the foundations using their own funds and provided invoices together with site progress photographs or a valuation report as evidence.

 

Question ten: Are fees payable to the finance company and mortgage brokerage deducted in full at the first drawdown, or in instalments?

Answer: Fees payable to the finance company and mortgage brokerage are separate from the loan amount. Collectively called finance fees, they do not affect the actual amount released at drawdown. Instead, the finance company lends the fee amount alongside the project funding: loan amount + finance fee = total loan amount.

For example, if a customer needs a loan amount of NZ$1,000,000 and the finance fee is NZ$30,000, the total loan amount is NZ$1,030,000. Before releasing funds, however, the finance company deducts the NZ$30,000 finance fee.

The vast majority of financial institutions in New Zealand deduct fees this way, although a very small number have their own arrangements.

About the author: 

 

York Zhang (Zhang Yong) 

Chairman of Huarong Finance

In 2006, York Zhang (Zhang Yong) founded Huarong Finance to provide the Chinese community with loans for homes, construction, businesses, land development, vehicles and heavy equipment. Combining his professional mortgage broking knowledge with his personal experience of living in New Zealand, York Zhang hopes to use Huarong Finance to bring more products tailored to the Chinese community’s circumstances and needs to market, develop more outstanding mortgage advisers, and unlock more funds from Chinese clients’ assets for reinvestment.